Usually private debt has a higher interest rate because the debt isn’t secured against an asset. For example, your credit card debt has no asset ‘securing it’ that a lender can sell should you default on the debt.
Car loans are cheaper than credit cards because there generally is an asset ‘securing’ the loan which is able to be sold should you default. A home loan is cheaper again because it is secured against an asset with a better resale opportunity should you default – your home.
This is then reflected in the rates that lenders set for unsecured debt such as credit cards (and some personal loans – eg an overseas holiday).
|Tax Rate||Gross Up Factor||Interest Rate||Pre-tax Equivalent Rate|
As illustrated in the table above, credit cards are incredibly expensive. They can easily equate to an effective pre-tax interest rate of almost 25% for a person earning up to $90,000 per year. What this means, of course, is that paying down credit card debt will earn a guaranteed 25% pre-tax return per year (under those assumptions). That’s an amazing risk-free rate of return. Of course it would be better to have NO credit card debt.
The biggest problem in managing debts (credit cards and personal/car loans) stems from the fact that a person with these debts is unlikely to have any spare cash available to pay down the debt. A wise course of action can be to consolidate the debts with a loan secured against your home, which will have a much lower interest rate.
A common example of debt consolidation is if you had equity in your house and are paying higher interest rates on personal debts. Consolidation will gain an immediate benefit in terms of reduced interest payments.
Typical moves to reduce or eliminate credit card debt via consolidation can include:
- Consolidating credit card debts by establishing a personal loan to pay out the credit card/s; or
- Consolidating credit card debts into a new credit card facility offering interest free periods on credit card transfers; or
- Consolidating credit card debts by redrawing on a home loan.
Number 1 is an appropriate course of action if you don’t have a current mortgage. But let’s examine options 2 and 3 in further detail.
Making use of an interest free period
In fact, if it is possible, implementing option 2 with either of options 1 or 3 is a good way to minimise the total cost of the credit card interest. It may be necessary to take advantage of the two-stage process if you don’t have the equity in your home or redraw facility necessary to pay out the credit card straight away.
With this approach you would apply to transfer your current credit card debt to another card provider offering an interest-free period. You focus on paying down as much debt as possible before the interest free period expires and the higher rate kicks in (typically after 6-20 months of 0% interest).
After the end of the interest-free period you can then redraw on your home loan to pay out the credit card balance. You will then pay interest on the redrawn amount at the lower home loan rate.
An example of this is highlighted below. Repayments are assumed to be a constant $200 per month (2% of the initial outstanding balance). You will note that the total amount repaid is around $7,000 less and you would save around 3 years with the alternative strategy.
|Credit Card Debt||17%||$10,000||88 months||$17,518|
|Alternative: Interest free card then home loan consolidation|
|Interest free card||0%||$10,000||18 months||$3,600|
|Use Home Loan||5%||$6,400||34 months||$6,883|
Consolidating your debt by using your home loan
The second part of the strategy works because it takes advantage of the lower interest rate attached to your home loan by consolidating the other expensive debt into a cheaper combined loan.
Let’s assume you consolidate the credit card debt into your home loan straight away. You have a:
- mortgage of $350,000 at 5% with 24 years remaining (repayments of $2,089 per month), and a
- credit card debt of $10,000 at 17% (repayments of $200 per month)
- Your total monthly repayments are therefore $2,289
Consolidate the credit card into the home loan over 24 years and continue paying $2,289 per month.
(Note: you could consolidate over a longer term than 24 years. This would reduce your monthly repayments but we advise against this in our article refinancing and how small savings on home loan repayments can cost a lot If you are struggling with the monthly repayments I will show you a way to reduce those shortly.)
By consolidating the savings will look like this:
|Total Time||Total Interest|
|Without Consolidation||289 months||$259,228|
|WITH Consolidation||257 months||$226,344|
That’s a saving of nearly 3 years and $33,000 just by restructuring the nature of the debt. This works because the home loan rate of 5% is so much cheaper than the credit card rate of 17%. When an extra $10,000 is added to the home loan the required repayment only increases by $60 per month. But you should continue to make the same credit card repayments of $200. This means that you are reducing the principal of your home loan by an extra $140 per month.
A little rejigging can go a long way.
Debt consolidation: refinancing your debts to a cheaper home loan
The above scenario assumes you consolidate your existing credit card/personal loan/car loan debts into your existing home loan. And it shows just how much better off you could be by moving to one total debt at 5%.
But what if you found a cheaper home loan? It would make sense to refinance ALL DEBTS to a new mortgage.
Let’s assume you have found a home loan 1% cheaper than your current one. This time, you would
- refinance your existing home loan of $350,000 and the credit card debt of $10,000 into one loan of $360,000 over 24 years at 4%
- The required repayment on this loan drops to $1,946 per month (rather than $2,289)
By consolidating the savings will look like this:
|Total Time||Total Interest||Monthly Repayment|
|Without Consolidation||289 months||$259,228||$2,289|
|WITH Consolidation at 5%||257 months||$226,344||$2,289|
|WITH Consolidation at 4%||224 months||$150,968||$1,946|
By consolidating all your debt to a cheaper home loan you will now save over 5 years and $108,000 in interest payments.
Better yet, you will save $4,116 per year in cash flow! For someone earning $85,000 that’s like receiving a payrise of over $6,000!
Would you like a tailored debt consolidation analysis?
If you are finding it difficult meeting your debt obligations or would just like to save some money so you can live your life more, own your home sooner or start building wealth then contact Moneybright on 1800 90 88 42 or drop us an email.